Advancing Economics in Business

Agenda Advancing economics in business Contract theory in regulation: the in-betweener of risks and incentives On 10 October 2016, Oliver Hart and Bengt Holmström were awarded the Nobel Prize in Economic Sciences for ‘their contributions to contract theory’. Their research has helped to define how contracts enable cooperation between parties with potentially conflicting incentives. Applications of this work can be found in many areas of society and policy, from employment contracts to corporate finance and governance. What has been its effect on regulation? As a research discipline, contract theory studies how people as the ‘front-loaded’ design of insurance contracts;² the make agreements in the context of the practical limitations design of CEO compensation packages; different corporate that they face in the real world. Both Hart and Holmström’s securities in corporate finance;³ and individuals’ incentives most significant contributions were in establishing strong to work hard even under simple fixed-wage contracts.⁴ The frameworks that could be used to consider real-world same theoretical frameworks in contract theory can be difficulties in writing contracts. applied to any other type of agreement or arrangement that relates to the economic interests of the parties involved. Contracts are formal agreements setting out the rights Regulations can therefore be considered a contract and responsibilities of the signatories. They are ubiquitous between the regulator or government and firms operating in economic life. We have contracts with our employers, in the regulated sector. Regulations guarantee firms some mobile phone providers, insurers, mortgage providers and level of certainty and benefits in return for the services they landlords. From one perspective, companies themselves provide. However, firms are also subject to various fines and are essentially a collection of contracts—between restrictions that would reduce their future profitability if they shareholders and the management; the firm and its failed to abide by the regulations. employees; the firm and the bank; and the firm and its suppliers. The fundamental purpose of contracts—or regulations in this case—is to provide appropriate incentives and rules Holmström and Hart’s contributions to the discipline are far- for regulated firm to achieve the best outcome for the reaching, but the areas highlighted by the Nobel committee regulator and thereby the consumer, be that lower prices are:1 or a higher quality of services. Since the regulator cannot monitor all business decisions made by the regulated firm, • Holmström’s contributions to the study of agreements it is not straightforward to design a regulation that would where the feature that the parties would like to contract appropriately incentivise firms to achieve the best possible on is hard to objectively define, but a strong, complete outcome from the regulator’s perspective—or the ‘optimal’ contract can nevertheless be written. For example, contract. an employer might want to reward an employee in proportion to the effort they exert—but effort is often Why not a contract based on hard to measure objectively; outcomes? • Hart’s contributions to the study of agreements in which it is difficult to map out all the finer details in advance. The most natural solution would be to design a regulation For example, firms embarking on a joint venture will based on outcomes that are observable to the regulator, struggle to map out what should be done in every such as prices. A regulator may then want to enforce a price possible scenario of market development. cap on charges imposed by regulated firms.⁵ However, these outcomes may be affected by factors that are not Holmström and Hart’s research has enabled economists to within the firms’ control. In the hypothetical example in study aspects of a wide range of real-world contracts, such Figure 1, when inputs are abundant and cheap— Oxera Agenda November 2016 1 Contract theory in regulation in the ‘good economy’ state of the world—it is possible for based on it, has been widely used in the UK to regulate firms to achieve a fixed price without incurring a loss. However, prices of privatised utilities, as it is considered to provide when cost of production is high—in a ‘bad economy’—firms more incentives for firms to innovate and improve may have no choice but to incur a loss in order to comply with efficiency than RoR. the regulator’s price control. Since neither firms nor regulators know what the state of the economy will be in advance, if Figure 1 Regulation with a simple price cap firms are not willing to take the risk of a bad economy, they will choose not to make the necessary investments and enter the market in the first place. This example highlights the difficulty of regulation based on a simple price cap. Holmström’s ‘informativeness principle’⁶ states that the regulator should allow adjustments to a fixed price control for external factors or ‘cost pass-through’ components, such as input and fuel prices. Price cap regulation is therefore preferable in sectors such as utilities, where regulators can estimate a fixed price and allow for cost pass-through components reasonably efficiently. Rate-of-return (RoR) or price cap regulation If regulated firms are particularly sensitive to risk—i.e. uncertainty about the economy, in our hypothetical example in Figure 1—then the regulator should strive to eliminate uncertainty for the firms, for example through RoR regulation. In this case, firms would be allowed to charge a price that Source: Oxera. would give them a level of return on top of their costs, as determined by the regulator.⁷ This would mean that firms can be certain about their ability to recover and make profits on Figure 2 Optimal regulation based on a firm’s their investments, regardless of the state of the economy. appetite for risk The well-known drawback of RoR regulation is that it removes firms’ incentives to innovate and operate efficiently beyond the level determined by the regulator. If firms are not very sensitive to risk then a form of regulation similar to a price cap may be more desirable. This is the trade-off between risk and incentives in any contract design, as illustrated in Figure 2.⁸ If the regulator is concerned about quality of service in addition to price, a simple price control regulation is not appropriate for achieving the desired outcomes. The multi-tasking model by Holmström and Milgrom shows that when quality is important but difficult to evaluate, too close a focus on price will result in distorted and undesirable outcomes for the regulator.⁹ Regulatory authorities around the world have used all of the contract and regulation designs described above, with varying levels of success. Note: Outside of regulation, there is also a spectrum of arrangements • RoR regulation was first developed and used to regulate with varied levels of risk and incentive for firms. For example, in many infrastructure-delivery models in the water sector, service and management prices of private or privatised public utilities in the USA. contracts allow only fixed payments, while ‘affermage’ (a contract granting However, it has been criticised for not providing sufficient use of property) and concession allow payment in proportion to the quantity incentives for efficiency improvement due to the trade-off of services provided, with added responsibilities. At the other end of the between risk and incentives discussed above. spectrum, design–build–finance–operate arrangements, joint ventures and divestiture give an independent contractor increasing responsibilities and a more variable stream of revenue. • On the other hand, price cap regulation, and variations Source: Oxera. Oxera Agenda November 2016 2 Contract theory in regulation • Ofgem, the energy regulator for Great Britain, has surround the trade-off between efficiency and quality recently moved from an RPI - X to a RIIO model,¹⁰ control, as formalised in Hart, Shleifer and Vishny’s with its greater emphasis on quality of service and framework.13 specific key outputs such as customer satisfaction and reliability. Ofwat, the economic regulator of the water industry in England and Wales, has taken a similar Theory of the firm: the ‘hold-up’ approach with TOTEX (total expenditure) and outcome problem delivery incentives, including both rewards and penalties. These regulations aim to provide balanced One of the most prominent contributions of Hart’s work is to incentives for both price and quality, instead of focusing the theory of the firm, which concerns factors determining only on price. the optimal size of firm. The 2009 laureate for the Nobel Prize in Economic Sciences, Oliver E. Williamson, and Incomplete contract: privatisation others emphasised ex post inefficiencies created by bargaining—or the ‘hold-up’ problem—where the private versus public ownership contractor must make an investment specific to the contract in advance and is thus at a disadvantage when bargaining If a complete contract is assumed, the implication is that it for its share of the profits.14 With this expectation, a firm is possible to put in place rules for all possible scenarios. may choose not to make the investment in the first place. Hart’s work on the theory of incomplete contracts stems The hold-up problem is particularly serious in long-term from the fact that, in many situations, it is difficult to write agreements where changes in regulations and policies may and enforce such a contract. In a world of complete lead to violations of the terms included in such agreements. contracts, the government can hire public employees and Oxera’s work as economics experts on behalf of the service specify via contracts what they need to do. Equivalently, providers in cases such as Tallinn Water vs Estonia15 and the government can sign a contract with a private supplier EDF International vs Hungary16 provides examples of how which, in turn, has contracts with its own employees.

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